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This is eleventh installment of the Asset Securitization series: and overview of Capital, Leverage and Loss in the banking system. After this post, I will drill down into the list of 32 banks on my Doo-Doo list with some more discreet info and then wind it up with a forensic analyis, or two or three - contingent on my time.
The Asset Securitization Crisis Analysis roadmap to date:
- Intro:
The great housing bull run – creation of asset bubble, Declining
lending standards, lax underwriting activities increased the bubble – A
comparison with the same during the S&L crisis
- Securitization – dissimilarity between the S&L and the Subprime Mortgage crises, The bursting of housing bubble – declining home prices and rising foreclosure
- Counterparty risk analyses – counterparty failure will open up another Pandora’s box
- The consumer finance sector risk is woefully unrecognized, and the US Federal reserve to the rescue
- Municipal bond market and the securitization crisis – part I
- An overview of my personal Regional Bank short prospects Part I: PNC Bank - risky loans skating on razor thin capital, PNC addendum Posts One and Two
- Reggie Middleton says don't believe Paulson: S&L crisis 2.0, bank failure redux
- More on the banking backdrop, we've never had so many loans!
- As I see it, these 32 banks and thrfts are in deep doo-doo!
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A little more on HELOCs, 2nd lien loans and rose colored glasses
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Will Countywdiw cause the next shoe to drop?
Thus far, we have reviewed the recent history of banking crises, the source of this current one in comparison to the S&L crisis, geographic losses, concentrations, delinquincies and charge offs. Now, we have to put these into perspective. For instance, a $1 billion loss can mean a lot more to a larger $60 billion company than it could to a smaller $40 billion company. It all depends on the amount of leveraged used by the company and its core/tangible capital. If the smaller company is less levered, it may have less assets, but also have more equity capital to act as a cushion. That is why those armchair investors that proclaim multi-billion, or trillion dollar asset, brand name companies are unapproachable just haven't done thier homework. Think of it in terms of buying a house. Just because someone gave you a 110 LTV subprime loan to by a McMansion doesn't mean you are wearlthy and immune to reproach. Not only are you able to be foreclosed on (just like everybody else who doesn't live on McMansion street), you arguably may be more prone to it thanks to the leverage you employed. Well, banks are the same way.
The more equity you have in your house, the more insulate you are from downturns and volatility in the markets. It really doesn't matter how big the house is or what brand name street you live on! With that being said, let's take a look at hose massive McMansions being built by culling random subset out of our Doo-Doo list.
As you can see, there are quite a few banks, some with well known brand names. I have defined leverage as tier 1 capital divided by average quarterly assets. Tier 1 capital ratios that drop below 6% invite regulatory intervention, which is why banks are in such a hissy fit to raise capital against the backdrop of all of all of those losses. Don't be fooled by the snake oil salesman line of "these asset values will return to a profitable position when the market gets back to normal". This is Reggie on earth beaming a message to all of those on Planet Overly Optimistic, the market is back to normal. If you lever up and buy a bunch of assets at the top of a bubble with borrowed money, you will be losing a lot on the way down. The market will not return to those bubble levels, on a real basis, for DECADES! Simple look back and let history speak for itself. Look at the charts below, and think of the morgtage and CDO assets as Yahoo stock Q1 200o. You, as a super smart banker, buy a million shares of Yahoo Stock on margin for $122 per share, using only $50 per share of your money since you are so smart, of course. Your plan is to take these shares, turn around and flip them to your clients for a profit, but all of a sudden the market drops and you are stuck with the product on your balance sheets.
Well, you tell your clients that the market is acting irrational and
will return, we just have to wait it out. So, you have $61,000,000 of
your capital tied up in $122,000,000 of this tech stock waiting for the
market to return. In the mean time, the market drops the price to $15
by the end of the year, effectively wiping clean all of your equity
and forcing you to recieve the margin call from hell. But wait, you told
your clients, accountants, lawyers, investors and regulators that this
was temporary blip and values will return back to pre-bubble times. You
see, that was Freudian slip. The asset values did return back to
pre-bubble levels, but you bought your assets at the peak of a bubble,
and leveraged up on top of it. When that return to the mean comes, it
will devastate those who used leverage. This scenario is only using 50%
leverage, or 2:1. The banks on my Doo-Doo list are using leverage above
6:1 to 11:1. Reference the first chart to see a sampling.
As
Stephen G. Cecchetti from the Center for Economic Policy Research (CEPR) points
out, the home prices have been in the range of 9 and 11 times the annual level
of rent paid. This implies an average user cost of housing of around 10%. However
since the beginning of 2000, home prices have appreciated significantly ahead
of rents. In 2006, the price-to-rent ratio reached an extraordinary high level
of 14 indicating creation of a bubble.
Source:
Federal Reserve of New York
and BEA
So, from a yield perspective, the bubble was immense as compared to the last 50 years!
Source: Professor Shiller's Irrational Exuberance
And from an inflation adjusted price perspective, as well as a spread of construction cost perspective, we had a historically tremendous bubble out bubbling everything since the Gold Rush ("Thar is gold in dem dar hills", said the bankers to the sheeple!)
So, if one were to compare the charts that exhibit rate, pace and quantity of the financial assets underwitten by the banks and thrifts on the Reggie Middleton Doo-Doo list, when do you think they will show a peak (hint, the housing market peaked 2005 and started droppin in 2006-7)?
Total assets securitized and sold by US financial institutions (US$ bn)
Source: FDIC
As they say on Dora the Explorer would say, you got it. Looking at total assets securitized and sold, it peaked as the housing market passed its peak and headed down. You couldn't script a better black comedy.
Share of total MBS issued – Agency v/s private label
Source: Securities Industries and Financial Markets Association
The private label MBS market also shows a peak just as the housing market past its peak and started to decline. Here's and excerpt from a previous article in the asset securitization crisis series, "However,
continuous inception of innovative (or complex) products and the
increasing number of private label MBS players led to competition in
the market. The major growth in market share for private label MBS was
observed in the period from 2003 – 2006, wherein the total MBS issued
by private labels increased at a CAGR of 30.8%. This led to a depletion
in the share of agency MBS over the years. In the context of
total MBS issued, the share of private label players in the MBS market
has increased to more than three times over a period of 12 years -
10.1% in 1996 to 33.1% in 2007!" Complex is usually a code word for less valuable for the client, more profitable for the vendor. The rapid CAGR period quoted above coincides perfectly with the peak years of the housing bubble.
While
MBS outstanding have grown at a CAGR of 10.1% in the period from
1999-2007, ABS grew at a CAGR of 13.5% over the same period. The
shrinking of a market with such high historical growth portends a
commensurate shrinking of bank revenues directly connected to the
underwriting and trading of these securities, as well as a decrease in
revenues of companies associated with the support of this industry, ex.
ratings agencies and insurers. What does this mean? It means that all of that non-interest income that lenders relied upon will dry up just as the income value drivers are minimized due to lack of demand and scarcity of capital. Less money, same risk since the banks are still stuck with leveraged liabilities and depreciating assets on (and off) their balance sheets.
Total outstanding - MBS market and ABS market
Source: Securities Industries and Financial Markets Association
Hey, again, bank management has allowed ABS and MBS growth and aggregate product outstanding to spike just as the market for the underlying starts to crash (remember those years from the earlier housing graphs - 2006-7).
One
way of understanding the importance of MBS in the US markets, is to
look at how much it constituted of the total US Capital Markets
outstanding at the end of 2007. The total value of mortgage
related debt in the US Capital Markets was 13.7% of total outstanding
value in 2007, second only to the equity markets! Moreover, mortgage
related debt was 24.1% of the total worth of the debt market (US$29.5
tn) in 2007! Thus, a correction on the order of the magnitude that we
are witnessing has not other option but to reverberate through the
entire US capital market system. We have already seen the effects on
the equity markets and significant portions of the debt markets. When
adding in the ABS related securities markets, further disruption is
inevitable. I would like to add here that this market comparison is for regulated markets. There is a market detailed in the asset securitization crisis series that dwarfs all of these markets, and it is UNREGULATED! It is also probably the next shoe to drop. See Counterparty risk analyses – counterparty failure will open up another Pandora’s box and Will Countrywide cause the next shoe to drop? CDS risk galore for more info.
Total US Capital Markets outstanding in 2007 (value: US$51.9 tn)
Source: Securities Industries and Financial Markets Association
Referencing the series of charts directly above, it is undeniable that the activity that took place over the last 7 years was bubblistic in terms of credit and real assets - the most bubblistic probably in the history of the US. Whether you use the historical real estate figures, rental yields, MBS, ABS, or even the CDS market or the dot com bust as a proxy, there will be a vey long time before one can profit at par value from the structured products written in the bubble. It has been 8 years since the peak in the Yahoo example, and absolutely no headway has been made. We are still about 1/9th the value of the peak level of that asset. Now, Real assets are more illiquid with longer macro cycles than tech stocks so if it takes 8 years and you still haven't made much headway,,, well I think you get the point. Expect much more than 8 years plus with leveraged products written on top of this real estate collapse. So the next time you hear a monoline CEO or banking exec exclaim that their bubblistic mark to market losses will revert to gains sometime in the future - DON'T HOLD YOUR BREATH waiting for the outcome! It is bound to be bad for your health.
The rise in
commercial and residential real estate loans resulted in construction and
housing market boom
Let's not just think in terms of MBS. After all, one
of the primary reasons for the asset bubble creation is the increase in the
loans toward the real estate sector which increased significantly during that
period. Loans toward real estate in the
US have grown at a CAGR of 11.7% in the period 1996-2006 to US$3,432 billion
(during S&L crisis the real estate loan market had grown at a CAGR of 13.1%
in 1976-1986). The construction and land development loan market has grown
at a CAGR of 20.6% in the period 1996-2006 to US$499 billion in 2006. This
implies the possibility that more supply was added to the market in this boom
period than in that of the S&L crisis. The growth in construction loans saw
an unprecedented rise in construction activity across the US attributable to
the strong demand for housing. The increased construction activity and the housing
boom along with low mortgage rates saw the US homeownership rates reach a peak
of 69.2% in 2004, at levels not seen since 1965, as compared to 64% in 1994 –
in the aftermath of the S&L crisis.
And as aggregate loans into the risky category of real estate increased, mortage rates (read potential profit margins) steadily decreased.
Source: FDIC
Please keep these last few charts in mind as we move forward...
Now, after that rather lenghty diversion, back to the doo-doo list.
Loans are risky, and you can see that the members of the doo-doo list took the risk plunge in the lending multiples of 4-9.5x their equity to generate this interest and fee income. They followed the trend of the general mortgage markets, its just that the members of the doo-doo list overshot the mark - buy a lot! The problem is that the music has stopped, and as you see from the property graphs above, it is reversing hard and appears to have a long way to go. At 9x your equity, all need is an 11% pullback to be out of business. There is not much room for error here boys and girls. Scroll back up to the property graphs and tell me if 11% is not a foregone conclusion (you know, like Dora the Explorer - hey, I have a 2 year daughter).
Above you see a subset of the Doo-Doo list with the loans in the previous graph broken out into a smaller subset to outline the riskier loans. As of the typing of this post, all of these stocks are down hard, yet relatively close to their 52 week highs. I don't believe they deserve to be there hence I am selectively and inexpensively shorting quite a few of them. This chart represents a cross section of risky loans as a percent of equity. Risky loans in this environment consist of equity loans, construction and development loans and commercial real estate loans. Notice how many of these companies have a tremendous amount (some upwards of 250%) of their equity in these high risk products. Now, if I aggregate the products and consder that aggregation the "extremely risky" loan category, then spread it across the whole 32 bank doo-doo list, we get...
We all know Countrywide and Wamu have big problems with high loans (that I thoroughly warned all of my blog readers of last year, way before the street and the media was aware of the extent of the problems - see
Yeah, Countrywide is pretty bad, but it ain’t the only one at the subprime party… Comparing Countrywide to its peers initially posted
Saturday, 08 September 2007).
WaMu and Countrywide were obvious shorts last year. WaMu actually took losses in its mortgage division for 5 straight quarters before the media and street caught on. Well, thes banks situation is just as obvious. Look at First Charter, Sandy Spring, First Horizon, Glacier Bancorp and Synovis Financial in comparison to the whipping boys of the financial media of today. They have much more exposure as a proportion of their equity - and this chart is not sanitized equity, it contains a lot of the bullsh1t that can be stuffed into the equity line that is really not equity. If I were to make it a trulyrealistic snapshot of equity versus the standard reported accounting fare, these stalks would be even taller in this graph.
I am going to cut this short here. The next post in this series will introduce you to my doo-doo bank short list template, wherein I will go over a few interesting findings with most of the banks on the doo-doo list. After that, we'll get into the forensics of Reggie valuation. I do hope this massive amount of buyside research is appreciated by the blog's constituency.
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Great work! Please keep it up.
Thanks,
Tom